Contango is a situation where the futures price (or forward price) of a commodity is higher than the expected spot price of the contract at maturity. In a contango situation, arbitrageurs or speculators are "willing to pay more [now] for a commodity [to be received] at some point in the future than the actual expected price of the commodity [at that future point]. This may be due to people's desire to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today." On the other side of the trade, hedgers (commodity producers and commodity holders) are happy to sell futures contracts and accept the higher-than-expected returns. A contango market is also known as a normal market, or carrying-cost market.
The opposite market condition to contango is known as backwardation. "A market is 'in backwardation' when the futures price is below the expected spot price for a particular commodity. This is favorable for investors who have long positions since they want the futures price to rise to the level of the current spot price".
Note: In industry parlance, contango may refer to the situation when futures prices (or forward prices) are above the current spot price, or a far-dated futures price is above a near-dated futures price, and the expectation is for the spot price to rise to the futures price at maturity, or the near-dated futures price to rise to the far-dated futures price.
The futures or forward curve would typically be upward sloping (i.e. "normal"), since contracts for further dates would typically trade at even higher prices. The curves in question plot market prices for various contracts at different maturities — cf. term structure of interest rates. "In broad terms, backwardation reflects the majority market view that spot prices will move down, and contango that they will move up. Both situations allow speculators (non-commercial traders) to earn a profit."
Contango is normal for a non-perishable commodity that has a cost of carry. Such costs include warehousing fees and interest forgone on money tied up (or the time-value-of money, etc.), less income from leasing out the commodity if possible (e.g. gold). For perishable commodities, price differences between near and far delivery are not a contango. Different delivery dates are in effect entirely different commodities in this case, since fresh eggs today will not still be fresh in 6 months' time, 90-day treasury bills will have matured, etc.
Description
The Commission of the European Communities, in a report on agricultural commodity speculation, defined backwardation and contango in relation to spot prices: "The futures price may be either higher or lower than the spot price. When the spot price is higher than the futures price, the market is said to be in backwardation. It is often called 'normal backwardation' as the futures buyer is rewarded for risk he takes off the producer. If the spot price is lower than the futures price, the market is in contango".
A normal forward curve depicting the prices of multiple contracts, all for the same good, but of different maturities, slopes upward. For example, a forward oil contract for twelve months in the future is selling for $100 today, while today's spot price is $75. The expected spot price twelve months in the future may actually still be $75. To purchase a contract at more than $75 supposes a loss (the "loss" would be $25 if the contract were purchased for $100) to the agent who "bought forward" as opposed to waiting a year to buy at the spot price when oil is actually needed. But even so, there is utility for the forward buyer in the deal.
Experience tells major end users of commodities (such as gasoline refiners, or cereal companies that use great quantities of grain) that spot prices are unpredictable. Locking in a future price puts the purchaser "first in line" for delivery even though the contract will, as it matures, converge on the spot price as shown in the graph. In uncertain markets where end users must constantly have a certain input of a stock of goods, a combination of forward (future) and spot buying reduces uncertainty. An oil refiner might purchase 50% spot and 50% forward, getting an averaged price of $87.50 for the one barrel spot ($75) and the one barrel bought forward ($100).
This strategy can result in unanticipated, or "windfall" profits: If the contract is purchased forward twelve months at $100 and the actual price is $150, the refiner will take delivery of one barrel of oil at $100 and the other at the spot price of $150, or $125 averaged for two barrels: a saving (gain) of $25 per barrel relative to the spot price.